Uncertainty is on the up again.
Fixed Income markets have traded in a narrow range over the past weeks after the volatility caused by last month’s US Employment report.
It has impacted the Historical Interest Rate volatility. However unlike previous declines in Historical volatilities, the Implied Volatilities over the past few days have reversed any decline and have risen this week.
And maybe more surprising is that the implied interest rate volatility is growing in the front-end of US Interest rates as much as the longer dated. Since the front-end interest rates should be anchored given the US Central Bank’s announcement on stable rates for the next 2 years, it is suggesting to me that the US Fixed Income market is continuing to be concerned about a summer crisis developing.
And yesterday the Euro zone crisis came back to the fore after a very downbeat assessment of the Euro zone economy from the ECB President and no announcement that the ECB would start to purchase Government bonds of the Periphery in the secondary market again. The ECB’s actions, as always, had unintended consequences. The ECB did cut the Repo rate to 0.75% and the Deposit rate to zero, this led to yields on 2yr German Notes falling 7bp to close to Zero and this morning have now moved negative. Spanish 10yr yields rose 40bp to hit 6.80%. Today 10yr Spanish yields are rising further.
The Greek coalition government announced that they would not ask the Troika to extend the maturity of the Bailout, just yet, as the EU and IMF told them that there would be no negotiations , which goes against the platform that they stood on at the election. It will mean that the opposition in Greece will have plenty of support in opposing the governments needed reforms. So there will be plenty of political posturing in Greece to hit the headlines in the next few weeks.
The supposed positive developments from the Euro Zone summit of last week is already unraveling. Now the details are emerging that any losses incurred by the direct lending from the ESM for Bank recapitalisation will be covered by the sovereign. So in fact the lending of the ESM becomes a liability of the sovereign anyway. So it is not going to reduce the debt burden on Spain or in the end Italy.
French Bond markets are having a strong rally today, after the government announced plans earlier this week to fund its budget deficit through €7bln in tax rises on individuals and companies. 10yr French Bonds now yield just 97bp more than German Bunds. What surprises me is that nearly every economist will tell you that these kind of measures do not, in the end, reduce the budget deficit as growth is harmed significantly. And as far as individual taxation goes, the French are specialists at avoiding high rates of taxation. Some increases in taxes may even be challenged in the EU courts as they appear to be targeted at non-French EU investors.
So whilst the rally in French Government bonds is occurring today, it is in a thin market and should be reversed in coming weeks.
And Risk markets are hoping.
Weaker economic news from the US has raised hopes that the US Central Bank will be announcing another round of QE at the August 1st meeting. We are back in the scenario that Risk markets rally and safe havens sell-off on weak US economic news just because the Fed will sail to the rescue. But, the economic situation has not deteriorated significantly since the last FOMC meeting. Just because the market chose to ignore the Fed’s own Business surveys in favour of the ISM surveys, doesn’t mean the Fed did. The Philadelphia Fed Business survey has been deteriorating for the past 3 months. Therefore it is very unlikely that the discussion at the August 1st meeting will be very different from the last meeting. So Operation Twist will be the only form of monetary stimulus until at least the end of the year.
It raises a conundrum about today’s US Employment report. If the Non-Farm Payroll number is above the consensus expectation of +100k growth, then the Risk markets may in the end take this as a negative as the expectation of QE will be reversed. The pricing in of QE has raised the S&P around 100 points from the release of the last Employment report. The first market to react to the prospect that QE3 would happen swiftly was Gold. 90 minutes after the release of the last US employment saw Gold jump nearly $50/oz. It is why Gold is selling off today, falling below $1590/toz, as yesterday’s ISM Non-manufacturing report raised expectations that the June NFP will be stronger than last month. So some Gold investors are already pricing out the prospect of QE3. I had forecast that EURXAU would rally to €1300/toz on weakness in Financial Credits, so whilst EURXAU did rally to €1300 yesterday it did so for the wrong reason.
The pricing out of QE3 in risk markets or in fact any benefit of it on the economy will happen in time, even if the US Employment report is weaker than expected today. And it is why yet again as US Treasury bond yields decline that Fixed Income markets continue to predict a weak Global Economic picture for the coming years. Risk markets are trading on hope that something will save them.